Thread by @teddyfuse

Have had a lot of questions about how #bitcoin ETFs interact with the underlying bitcoin market throughout the trading day, when ETF buys and sells impact the spot bitcoin market (and how and when the ETF actually gets its bitcoin). Short thread.

Have a read through our thread on Alice, the end user, and Mallory, the market maker. We’ll use the same characters.

https://x.com/teddyfuse/status/1760287707018793420?s=20

Typically, the cycle starts with Alice.

She’s at home, logged into her Fidelity or Schwab account or similar, and decides she wants to buy $100 worth of a bitcoin ETF.

She goes into her account, punches up the ticker; clicks buy.

As described before, she could either be buying this $100 of shares from Bob (who happens to be selling at the same time) or from Mallory, who is a market maker.

Let's assume in this scenario she buys from Mallory.

Mallory, as a market maker, is an arbitrageur. She doesn’t want to be long or short bitcoin, and doesn’t seek to profit from the price going up or down.

She wants to make a spread on the difference between the prices at which she can buy ETF shares and sell them, while hedged.

So when Mallory sells the $100 of shares to Alice, Mallory simultaneously buys a long position in the underlying asset, bitcoin, to hedge her position.

She can do this any number of ways - buying BTC spot, buying BTC futures, buying another bitcoin ETF, buying other BTC derivs.

In this way, as soon as Alice buys the $100 of ETF, and Mallory sells it to her, she becomes short the shares of the ETF and simultaneously becomes long the underlying corn. Mallory is running a hedged book (while Alice is taking outright directional risk, long).

This is the moment when Alice’s purchase of ETF, although not directly interacting with the underlying bitcoin market, indirectly impacts supply/demand in the bitcoin market, by pushing that demand to Mallory, who is out bidding for corn.

Mallory’s "hedged book" position is now LONG bitcoin and SHORT bitcoin ETF (fully hedged, or risk neutral, or delta-one, as Wall Street calls it).

If BTC number go up, her hedge makes money while her short ETF position loses the same amount. And vice versa.

This happens hundreds of thousands of times throughout the day (in all ETFs, not just BTC).

As Eric pointed out last week, in one single session, one of the bitcoin ETFs alone had over 100k individual trades

https://x.com/EricBalchunas/status/1762591377446285737?s=20

Towards the end of each session, Mallory looks at her book to see where she wound up after the day of trading.

Let’s keep it simple and assume the only trade she did was with Alice. She sold $100 worth of ETF to Alice, and bought $100 of bitcoin exposure like we talked about.

Mallory doesn’t want to take up any balance sheet overnight, wants to go home “flat.” She has to unwind both the short ETF position and the long bitcoin position. She wants to lock in her arbitrage gain and go home for the day. Work is almost done.

Mallory calls up the ETF issuer (or its Administrator), and says “I want to create $100 of the ETF.”

She enters a ‘Creation Unit’ order with the ETF, and at the price of that night’s closing NAV, the issuer will mint $100 worth of new ETF Shares to give to Mallory.

The Creation Order flattens Mallory’s short position in the ETF - the sale of $100 that she made to Mallory, that made her SHORT the ETF is now covered at tonight’s NAV, and that side of the book is flat.

Unless she does something else, she'd no longer be fully hedged / delta-1

So Mallory now needs to unwind the LONG position in the underlying BTC in order to go home flat risk and lock in her arbitrage profits on the trade. She'll want to do so at ~the same time and price that the ETF is buying corn and calculating it’s NAV. She's a seller now.

But in that moment, the ETF is a buyer. The ETF has to go out and buy $100 worth of coin as a result of the $100 Creation Unit order.

So the ETF turns around and goes out to the market to buy $100 of BTC, and is likely to be targeting the same benchmark that Mallory is.

The ETF is now a buyer of BTC in the market at the same time that Mallory is a seller.

They are on opposite sides of the market in similar size & with similar price goals.

Mallory sells, the ETF buys; & now Mallory is out of the long position, flat risk, and can go to the bar.

The ETF is now long $100 more bitcoin, has issued $100 more of shares, has $100 more in net assets.

Alice has a long position of $100 worth of bitcoin via the ETF.

All of this happened behind the scenes from Alice’s perspective, when she clicked the button in her account.

The next set of questions comes up around settlement: how do the Shares that the ETF issued actually make their way into custody at Alice’s broker? That’s a question for another day though!

This is an overly simplistic example, and assumes a vacuum of activity where nothing else is impacting Mallory. IRL, that is not the case, and there are more complex dynamics at play (including the basic fact that a single creation unit is much larger than 10 shares) etc.

Mallory has a bunch of other things to think about, including current and prior inventory and positioning, cost of capital, balance sheet usage / availability, cost to create/redeem, availability of other hedges and borrow rates, etc. Fin/